Summary.   In last months article I gave the opinion that coming changes in favour of landlords including the slow restoration of interest expense deductibility and no fault tenancy terminations would encourage investors but that there would be no frenzy. I retain that view even though the key factor which caused investors to back away from the market early in 2021 - progressive loss of interest expense deductibility - is going to be reversed a lot more rapidly than expected.

Monetary policy not yet easing

Tony Alexander

Friday 15 December ‘23

Investors will be able to deduct 80% of their interest expenses from rental income starting from April one next year with 100% deductibility a year after that. 80% is as good as 100% in the minds of most people therefore it seems reasonable to expect more investors to return more quickly.

But we still have the same problem I mentioned four weeks ago. Landlords face rapidly rising and high costs for running their rental businesses. Concerns continue to grow about rising maintenance costs, insurance premiums, and council rates. This is understandable in light of reports for instance of 30% increases in insurance premiums in the Wellington region being implemented at the moment, plus councils warning about further substantial increases in rates in order to cover deferred maintenance costs.

The interest rates which landlords pay are also still at relatively high levels and although the direction of movement is now likely to be downward the pace of decline is likely to be relatively slow initially.

The Reserve Bank have just conducted their regular review of the official cash rate and surprised no one when they decided to leave it unchanged at the 5.5% level it was taken to at the end of May this year. Inflation in New Zealand has fallen and now sits at 5.6% compared with 7.3% over a year ago. But this rate is still much too high and a key thing which the Reserve Bank needs to see happen before they can be confident that inflation will continue to fall away at a strong pace is for the moment simply an article of faith.

The pace of wages growth is highly likely to slow down rapidly as a result of the substantial easing of labour market conditions over the past year. Record net migration inflows have given employers much more choice when it comes to finding staff and economic theory tells us this improvement in the demand and supply interaction will generate slower wages growth.

But as yet there is little statistical data showing that wages growth is in fact slowing down. And that is where 5.6% inflation becomes a problem. There is no ability at the moment for the Reserve Bank to take the risk of backing economic theory and cutting interest rates.

If wage growth doesn't slow down and if inflation holds up then they would have to quickly reverse any rate cuts and that is the last thing a central bank wants to do.

With a reasonably muted outlook for the New Zealand economy next year including falling house construction and poor growing conditions in the farming sector we can reasonably expect the rate of inflation to fall away towards 3% within 12 months. That means we can also expect falling interest rates. And in fact come the next review of the official cash rate at the end of February next year we will hopefully have solid proof of slowing wages growth alongside further declines in business pricing intentions. If we do get these things and if the inflation trends overseas continue to look good then we might get our central bank signalling a cut in the official cash rate in the second-half of 2024.

If they do that then we can expect immediate falls in wholesale borrowing costs facing banks and declines in fixed mortgage rates straight away. Actually, we are quite likely to see declines in fixed rates before then because the inflation outlook in the United States has improved quite a bit and wholesale funding costs over there have fallen away. Scope actually exists in New Zealand at the moment for banks to cut their two year fixed mortgage rate by 0.5% while leaving the margin they earn on that product at about average levels.

But the absence of Spring mortgage campaigns from the banks this year tells us that for the moment they are not focused on growing market share. At some stage their focus will shift to that but there is no way of knowing when this will occur. I see a good chance it will happen before February and so as we get through summer I do think there will be some small declines in fixed mortgage rates and that these declines will increasingly solidify the decisions of many investors and first home buyers to make a property purchase sooner rather than later.

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